In this, the third of the four part series, we discuss what's involved in institutionalizing innovation.

SD: How do we make innovation part of everyone’s job?

GH: Management was created to drive the variability out of the workplace and to drive conformance in. When you visit an Intel fab-line and see them creating minuscule nano-chips with unbelievable tolerance and precision, it’s awe-inspiring.

But we also live in an experience economy where more and more of the value is being created at the intersection between the employees and the customers. As the foundation for economic value changes, innovation becomes more important for several reasons.

First, we live in a much more competitive environment. Many of the barriers that used to protect companies from the winds of competitive destruction are crumbling. This includes distribution monopolies, customer ignorance and proprietary technology.

Just think about the fact that Apple [AAPL] was able to get into the mobile phone business in about 18 months from a standing start. Much of the technology and knowledge to create a mobile phone is commodity knowledge. You can buy it from somewhere around the world for next to nothing.

So we live in a world where the barriers to competition are coming down. Knowledge itself is becoming a commodity. In this environment, the only way you protect yourself is through innovation. That’s because, first, the locus of value creation has shifted closer to the customer. Second, the barriers to entry have broken down. And third, knowledge diffuses rapidly. So the premium on innovation goes up.

Less than one company out of a hundred has made innovation part of every employee’s job. Even those companies that have experimented with idea markets have found the experience disappointing. This is partly because firms try solve the problem of innovation by one-shot solutions. They have an innovation awards dinner or run some brainstorming sessions. We need a much more systemic approach.

Here’s an analogy. If you look over the last two decades, many big firms have put a huge amount of energy into re-engineering their business processes. This included their logistics supply chain and their customer support systems, to meet the challenge of efficiency and agility. This monumental effort is what built Enterprise Resource Planning systems with firms like SAP [SAP].

We now need a similar degree of effort, although it doesn’t need to be as expensive. We need a similar commitment, not to re-engineer the business processes for logistics, but to re-engineer how we hire, how we reward, how we allocate resources, so that we have processes that are more friendly to innovation.

To give you a few examples, very few companies have trained every employee to be an innovator. You can teach people how to do this. I like the analogy of learning the golf swing. It’s a complicated set of skills, but you can teach people how to do it.

So when employees come up with an idea, we are generally going to be disappointed. That’s because either the ideas are small and incremental and get a kind of, “So what?” response, or the ideas are wild flights of fancy and get a reaction of “No way!” What we’re not likely to get are ideas that are both radical and practical. That won’t happen unless we teach people how to think about innovation and provide them with the resources to do it.

Think about resource allocation for first level employees and even second level employees. They have a difficult time getting even small amounts of experimental capital or time to work on something that’s new. Suppose I have an interesting idea and I need to spend half of my time for a couple of months, along with $5,000 or $10,000 of experimental capital to build a prototype or to travel and talk to some customers so as to get a better understanding of their needs. Most employees don’t even know where to begin to get that kind of time and money. In most companies, even for very small amounts of capital, they have to go through a very bureaucratic process to get it. So how do you reverse the allocation of the budget so that people can easily get small amounts of capital and experiment to try new things?

Or suppose we look at project approval. Typically any incremental investment has about a 90 percent chance of earning a solid return. Yet by definition, when we undertake basic innovation, most of the ideas that we start out with are going to have less than a 25% probability of success.

When venture capital firms put together a portfolio of new companies that they are funding, the most likely return on every one of them is zero. However the average return on all of them can be very high, because you have one or two companies that may become the next eBay [EBAY] or Facebook. When you look at that investment stream as a portfolio, it looks different. Venture capitalists are almost always wrong, when they are right, they are really, really right.

Inside companies, managers don’t think this way. If a couple of employees have an idea and say to the management, “We’d like $5,000 to work on this even though it has at best a 20% chance of success,” nobody will give them any funding.

In industry after industry, venture capital has funded insurgents, some of whom end up beating the incumbents. The incumbents have more financial resources. They have more people. They have more customers. They have every possible advantage they could have. And yet the insurgents often win. This means that venture capital is generally better at putting capital behind new ideas than established companies. Yet that isn’t written into the constitutions of these firms. It’s not something that can’t be changed. But we don’t yet have processes within the firm that support experimental capital for innovative ideas at a very early stage of development.

So if companies really want to be serious about innovation, that’s what they will have to do. They will have to change how they hire, how they train, how they compensate, how the senior executives operate, and how they deploy capital. They are going to have to ask about every one of those processes: how can we turn this into something that facilitates innovation?

SD: So have firms like Whirlpool [WHR] and Apple shown us how to institutionalize innovation?

GH: Even in those organizations, it’s a constant never-ending struggle. There is lot of backsliding. What companies like these will tell you is that they have made progress but they aren’t yet sure that they have found the way. As companies scale, they find it harder and harder and some of the old management 1.0 behaviors start to take over.

Part of that derives from the fact that bureaucracy was intended to solve the problem of coordination at scale. So when you visit an Intel [INTC] fab-line or when you watch an Airbus A-380 being assembled, you realize that these things require an enormous amount of control and coordination. Historically, the only way we knew how to get that was with hierarchy.

Morning Star is a refreshing example of management innovation. It’s a company that is precisely synchronized and radically decentralized. Economists would tell you that this is impossible. They would say that you can have markets that are loosely coupled and highly decentralized. But you can’t have an organization that can produce something complicated that is also decentralized.

For economists, the very definition of a firm, as opposed to a market, is an entity that is centralized.

So there’s still a lot of thinking to be done. In essence, what we are doing is trying to resolve a set of tradeoffs. The question we’re asking is: how do we build companies that are both big and flexible, both disciplined and empowering, both focused and opportunistic, both pragmatic and principled and both rational and intuitive? The resolution of those tradeoffs is going to take fundamental innovation.

It is like when Toyota was figuring out how to get low cost and high quality at the same time in auto manufacturing. That was a manufacturing revolution, with statistical process, Pareto analysis and the training of employees to be real-time problem solvers. It will take a similar revolution here as well.

A firm like Morning Star which implements the idea of self-management which is training blue-collar workers to do ROI calculations, in which every employee can spend the company’s money, and in which performance evaluation is peer review rather than top-down controls to keep people in check, is showing us the kind of revolution that we need.

Even many of the companies that are talked about as being in the vanguard are still dinosaurs. They can run faster. Maybe they can reach a little higher on the tree. But they are still dinosaurs. I don’t think we have yet resolved this problem.

My new book, "The Age of Agile" was published by HarperCollins in 2018. I consult with organizations around the world on leadership, innovation, management and business narrative. For many years I worked at the World Bank, where I held many management positions, including d...